Alternative Energy Mutual Funds and Exchange Traded Funds (ETFs)

Mutual funds are often touted as an inexpensive way to achieve
diversification. With declining brokerage commissions, this is often no
longer true. If you are interested in investing in alternative energy, is
a mutual fund or ETF
right for you?

Here are the currently available mutual funds and ETFs of which I'm aware
with alternative energy type themes:

* These funds are too new to have published turnover ratios,
but I anticipate that they will have low turnover (<10% annual) because they
are index funds.

Diversification reduces the company-specific risk of a portfolio, but leaves
market and sector risk. Most
of these benefits can be captured with a 30 stock portfolio, with greater
benefit accruing to investors who make a conscious effort to choose dissimilar
companies. So to determine if a mutual fund, ETF, or stock portfolio is
the most cost-efficient way to achieve diversification I will compare the costs
across portfolio sizes and time horizons.

The following chart shows the amount of money you will have after the given
time period, assuming that the underlying stocks return 10% per year, and
dividends are reinvested (which can be accomplished commission-free via DRIPs
in a stock or ETF portfolio.) The 10% return is simply a guesstimate
included for demonstration purposes and is in no way to intended to be an actual
prediction of returns. There is never any guarantee of future results.

Values in bold indicate the best investment option (given these
assumptions) for any time period/initial investment combination.

Initial Investment

1 year

3 years

5 years

10 years

$1,000 in GAAEX (only available for IRAs)

$1082

$1266

$1463

$2119

$1,000 in NALFX

N/A

N/A

N/A

N/A

$1,000 in Powershares

$1076

$1282

$1536

$2397

$1,000 in 30 stocks

$605

$732

$886

$1427

$2,500 in GAAEX (only available for IRAs)

$2700

$3151

$3677

$5407

$2,500 in NALFX

$2590

$3063

$3622

$5509

$2,500 in Powershares

$2716

$3245

$3876

$6047

$2,500 in 30 stocks

$2255

$2729

$3301

$5317

$5,000 in Powershares

$5449

$6509

$7776

$12,130

$5,000 in 30 stocks

$5005

$6056

$7328

$11,801

$10,000 in Powershares

$10,914

$13,038

$15,576

$24,297

$10,000 in 30 stocks

$10,505

$12,711

$15,380

$24,770

$20,000 in Powershares

$21,843

$26,095

$31,175

$48,630

$20,000 in 30 stocks

$21,505

$26,021

$31,486

$50,707

An examination of the chart reveals that, at the minimum investments ($2,500
for non-retirement accounts) for NALFX and GAAEX, it is always cheaper to buy
one of the Powershares ETFs for a $15 brokerage commission than to pay the high
expense ratios and possible load for the traditional mutual funds. Even
the $1000 minimum for retirement accounts allowed by the GAAEX is only a bargain
for holding periods less than three years, after which the nearly 2% expense
ratio eats too much into the gains.

This demonstrates the well
known advantages of using low-cost index funds (in this case index-ETFs)
over traditional mutual funds, but as we move to accounts in the tens of
thousands of dollars with longer holding periods, even the low 0.7% expense
ratios of the Powershares ETFs start adding up, and paying $15 a trade to buy a portfolio
of 30 stocks begins to look better. If you consider that $15 a trade is
fairly costly for most online discount brokers these days, and many offer
free trades for qualifying accounts.

This leads to the question, if your alternative energy portfolio is in the
sweet spot to use the Powershares
ETFs, which one(s) should you choose? The answer will depend mainly on
what motivates you to invest in Alternative Energy in the first place. If
you're most interested in Global Warming, you will gravitate towards PBW.
PUW caters to investors concerned about energy security, and PZD companies focus
most strongly on traditional environmental issues such as pollution. For a
$3000+ portfolio, the extra commissions involved in splitting your portfolio
between two or three will not have a significant impact on your returns.
Or you could buy one, and when then buy a different one when you have more money
to invest.

Finally, if you have $20,000 or more to invest, and and can leave it there
for a few years, what stocks should you choose? If you don't have time to educate
yourself about alternative energy stocks, the simplest way to go about it is
look at the holdings of the mutual funds or ETFs you would have bought, if they
were not too expensive. PBW,
PZD, and PUW
have lists of holdings that are particularly easy to use. It may strike
you as strange, to buy a basket of stocks with so little research into the
actual companies, but that is exactly what you are doing when you buy any index
fund... this technique just lowers the fees if your account is the right size.

Caveats

I have ignored some oft-cited advantages of mutual funds in this analysis,
most importantly the ability to make small,
regular investments for dollar cost averaging. I consider this more a
matter of self-discipline than good investment strategy. The point of
dollar cost averaging is to discipline ourselves into buying more of a fund when
it is relatively inexpensive, and less when it is more expensive (even when we
don't really know what expensive or inexpensive is.) Nevertheless, if automatic
payments are the only way to force yourself to invest, you can always set up
automatic payments into a money market mutual fund, and whenever that fund
reaches some fixed amount over something like $1000, you can invest the money in
an ETF, or add a stock to your portfolio. These investments can be used to
maintain a balanced portfolio by always investing in underperforming sectors.

None of the investment options I have discussed are truly diversified
portfolios; a diversified portfolio will contain investments in a broad range of
industries and asset classes. For most investors, alternative energy
should account for only a fraction of the entire portfolio. If investment
in alternative energy is taken as part of a broadly diversified overall
portfolio, there is less need to own as many individual stocks for
diversification, so long as no one stock comprises more than 2-4% of the entire
portfolio. This makes the individual stock method of investing more
attractive, as it will require relatively fewer transactions.

It is often said that people have learned about the importance of portfolio
diversification and are using mutual funds to acheive this. Given
well-managed funds with low management fees, this argument makes some
sense. But many funds charge such high fees that investors might be
better off trying to achieve diversification themselves, if diversification is
the primary investment motive. Moreover, when they are investing outside
of a tax-free environment, by holding stocks directly investors can avoid
capital gains taxes on the gains the mutual fund managers realize when they
sell stocks in the funds' portfolios, an important issue with higher turnover
funds. Investors can instead realize, for tax purposes, the losses on
the stocks that go down. Mutual funds clearly have their limitations.

DISCLOSURE: Tom Konrad and his clients do not have positions
in any of the securities mentioned here, although they do have positions in many
of the stocks owned by these funds.

DISCLAIMER: The information and trades provided here are for informational
purposes only and are not a solicitation to buy or sell any of these securities.
Investing involves substantial risk and you should evaluate your own risk levels
before you make any investment. Past results are not an indication of future
performance. Please take the time to read the full disclaimer here.